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Short Selling 101

There is big money to be made on the short side of the stock market. But the public is not short-sell minded. We advise a toe-to-the-water approach. Try it slowly and see. It’s not so cold. In fact, it’s fine once you get in. You gain confidence that you can handle any market direction! But know the ropes first.

In theory, short selling can cost you more (because a stock you buy at $20 can only go to zero, but a stock you sell short at 20 can go to 60 or 400). But, if you follow the strategies outlined below and the stock market advice in this Stock College, this should never happen to you. A simple stop-loss order gives total protection.

What is Short Selling?

A short sale is one in which borrowed securities are used for delivery to the buyer (in the transaction in which you sell short). The process is not complete until the seller discharges his obligation to the lender by delivering to him the securities to cover the short sale.

Many will not grasp how they can sell what they do not own. It is possible because of your broker’s facilities for borrowing stocks with which he is able to make delivery for you. When you sell short and your broker has borrowed a portion of stock and delivered it to the purchaser, the first part of the transaction is complete.

Covering the Short

As with all trades, there remains the second half, that of covering your short. That is, providing your broker with an equivalent amount of stock at a later date so he can return it to the person or broker from whom he borrowed it (which you do by telling him to ‘buy to cover’ the short).

But you can take your sweet time about this second half of the deal. Unlike if you buy a put option (which in simplified terms is a highly leveraged short sale), when you have a specific date by which you must exercise your option, you don’t have to cover your short sale in any specified time period. In theory, this can be many years. There is no time limit, provided your account is in good order.

Under US laws, short sales are only possible on upticks, which means the stock must move up 1/8 of a point, after reaching your short-sell price, to be executed. If a stock only moves down, you’ll never get short in it. (Laws vary from country to country.)

So, you get an execution. They credit your account with the proceeds of the amount of shares you have sold short at the price at which you shorted it, just as in any other sale of stock. Now, let’s say that stock dropped 10 points. You decided that was low enough and you wanted to take a profit. You called your broker and said, ‘Buy 100XYZ to cover my short at 45 or better.’ In this case, ‘or better’ means or less.

Let’s say an execution is made at 44. Now, ignoring the commissions, you made 11 points. You sold at 55 and later bought at 44. It’s just the opposite of buying at 44 and selling at 55.

Short-Selling Tactics

Short sales should always be protected with a stop-loss order so that if it does not immediately go as you planned, you are out with, say, a 1015% loss (based on the chart) and that’s the end of it. No nightmares, no big risks. The time to place a stop-loss order is the day you take a new position in a stock. At that point, you can do it objectively. Later, you start rationalizing. And, often, ‘later’ never comes. So, put in the stop-loss order the same day you short. However, the chart pattern may change and alter the best place for a stop, so never just place a stop and forget about it.

The stop-loss order on a short sale is just the same as on a long position, only in reverse. You order the stock bought if it goes up to a certain price. As a matter of tactics, I would warn against shorting after a stock has fallen sharply. Chances are always good that the stock will rally after a sharp fall, whether or not it later falls again. And that rally would either scare you out or hit your stop-loss order; either one causes you an unnecessary loss.

The time to short is at the start of the fall, based usually on its chart pattern and/or perhaps on your analysis that the market as a whole is due for a fall.

Selecting Stocks to Short

Great care should be exercised in picking stocks to short to get the ‘most mileage’ for your position. Stay away from stocks with a small number of shares outstanding. Avoid stocks that already have so many people short in them that the situation can boomerang.

Short selling is a tricky business, but those in a position to do a little homework can weed out the most logical candidates for profitable shorting especially during bear markets. Our number-one rule for short sellers is:

  • Short positions should be protected against more than a 10-15% loss with a ‘stopbuy’ order placed with your broker at the time you make the short sale.

The one final rule:

  • Once you have a profit, move your stop down and keep it moving as the price falls (a trailing ‘stop-buy’ order).

The Morality of Shorting

Many people instinctively  feel  there  is  something indecent about it (see Short Selling – Is it Unpatriotic?). But, when the facts are clearly brought to light, opposition to it disappears. Napoleon, for example, thought short selling in the French Bourse was unpatriotic. But Gaudin explained to Napoleon that those who did so were “expressing their judgment of future events,” and “not their wish” for the country.

Before you start short selling, try making a map of your shorting process on paper first. This will help you when you are ready to take the plunge into the deep blue ocean.

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